Thursday, October 23, 2008

Why the fall in the gold price when physical gold remains in huge demand?

Contrasting views on the reasons for yesterday’s gold price fall come from Mineweb’s Barry Sergeant and from Jeff Nichols of American Precious Metals Advisors, and both are almost certainly relevant at the current time.

Author: Lawrence Williams
Posted:  Friday , 17 Oct 2008 


"Why was gold down so sharply yesterday?" asks gold guru Jeff Nichols of American Precious Metals advisers - "and this in the face of reportedly record demand from investors for bullion coins and small bars?"

This seeming disparity in the overt supply demand situation looks like an anomaly, but Nichols points out that news that European central banks sold 7.6 tons of gold in the week ending October 10th has certainly been a heavy burden on the price and helps explain why the  metal could not move higher last week and, if selling has continued, in the past few days.

But, Nichols reckons, it has been central bank gold loans -- even more so than official gold sales -- that have really pulled the rug out from under gold.  Gold loans by central banks are an alternative -- and invisible -- means of injecting liquidity into the banking system.   These gold loans to banks and bullion dealers by the leading central banks are probably a significant multiple of outright official sales.  

In simple terms, a central bank may lend or deposit gold with a banker or bullion dealer who simultaneously sells forward.  Even with the recent substantial increase in gold-lending rates, at the end of the day the dealer receives cash in the transaction at a cost that may be advantageous to short-term money-market borrowing costs.  Central banks have great freedom to lend gold outside their government-mandated rescue programs and these lending activities are typically hidden by their accounting practices.  

Interestingly, just as some of the major central banks have stepped up lending, there have been reports of other central banks withdrawing deposits to avoid the counter-party risks.  

Nichols also notes that at the same time, there have been reports of gold sales by hedge funds to cover losses in equity markets. In most cases, these sales are unwinding of long futures positions -- and do not help offset the record physical demand for gold we have been seeing from virtually all four corners of the globe.  Institutional trading of gold and now net sales have added to market volatility, making gains in the past few weeks difficult to sustain, but do not explain yesterday's sharp decline.

But, Nichols avers, in contrast to the day's gold headline news, continuing strong physical demand for gold has to be a harbinger of gold's ultimate ascent.  

"It's no longer just "gold bugs" buying the yellow metal but regular investors and savers of all stripes." says Nichols.   "These are not traders looking for quick gains but scared people driven by fear seeking to protect their wealth." 

This is why the demand for gold bullion coins -- the U.S. Eagle and Buffalo, the Canadian Maple Leaf, the Austrian Philharmonic, and the South African Krugerrand -- is at levels not seen in three decades and why bar fabricators serving European, Middle Eastern and Asian markets are reporting increasingly long delivery times and rising premiums.  

Gold-backed ETFs are also seeing a continuing, albeit erratic, inflow of funds resulting in a growing pile of bullion held on deposit.  By this Wednesday of this week, the NYSE-traded SPDR Gold Shares, were backed by more than 770 tons of physical gold held on behalf of fund investors.   

Recent data indicate that the major industrial economies are headed into a deep, prolonged, synchronized recession -- or worse.  Oil and industrial commodity markets are also confirming these same dire expectations.  But a deeper downturn means that policy makers will need even more aggressive monetary ease and fiscal spending to breathe life back into the sick economy -- and governments will be even deeper in the hole.  

Nichols says he is bullish on gold because, in the end, as the global economic recession deepens, governments will find the only way out of this mess -- the only way to pay for all the bank equity positions and private debt they are accumulating and to pay for the coming "New Deal" type programs and possible industrial bail-outs -- is to print more money.  In other words, to inflate, and gold typically is a proven hedge against inflation.

There may well be other aspects though which need to be taken into account, notable among which is the idea among some investors seeking safety in their investments is that the dollar and US Treasury bonds, and also the Japanese yen, are as good a safe haven as gold, or in some views better.  In his article on this site yesterday - Has gold bullion lost its compass? Barry Sergeant puts forward this alternative view, yet the truth may well be a combination of all of the above.  Sergeant is less confident about the medium term prospects for gold than Nichols - indeed veers towards the bearish for gold in US dollar terms implying the dollar's appreciation against other currencies, and against gold, may well continue in that people prefer to put their trust in the world's strongest economy (even if it is going through an extremely difficult period).  As he puts it the US economy "by definition, would be the last to go down if the entire global economy falls over. Even in that putative post apocalyptic world, dollar denominated paper would likely open the gates in the exit from Armageddon."


Some might consider this an optimistic view of the US economy given the huge deficit which is being run which, in theory, should put the currency in the doldrums, but with most other Western economies almost united in their support of the banks and financial institutions, and needing to print money to do so, perhaps the US is as good as any.

Inflation may thus be the key to gold's strength or otherwise.  Fundamentals remain positive for the yellow metal, but current markets seem to ignore fundamentals and logic, not only for commodities, but for nearly all classes of stocks.  Recession, which most people think is coming - or may even be here already, does not necessarily imply a major growth reduction.  It can be a zero growth scenario, yet the fall in the markets seems to be anticipating something far worse which may, or may not, materialise.  We can talk ourselves into total collapse if we are not careful.

As for gold - whether it is considered a better safe haven than the dollar or US Treasury bonds or not, it is still considered a safe haven and will continue to attract investors looking to protect their capital.  The dollar could well falter again and then gold could see a new surge, but in the meantime it has performed far better than nearly all other commodities and stocks and there seems to be no real reason why it may not continue to perform in this niche.  Volatility is likely to continue but overall one would look for a continued better performance against stocks and industrial metals and overall growth even in dollar terms over the next few months.  But the ride may not be an easy one.

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